Flat Tax Fever

Well, it’s the silly season again, and Republican candidates are scrambling all over each other to get their tax simplification plans in place. Governor Rick Perry, for example, proposes a simple 20% flat rate (NYTimes, 5 Nov 2011), which is most assuredly a part of a secret jobs creation program for editorial cartoonists. Cain’s 9-9-9 plan fared no better.

These plans, and plans like them, are popular not because they are fairer than the existing plan, but rather because they are simpler. The byzantine US tax codes are legendary, and the immediate appeal of these plans is their simplicity, a simplicity that promises to remove all those special interest advantages that so distort the free market that we believe in.

The guiding idea behind the flat income tax is the idea that all taxpayers should be treated equally, but any introductory economics class will certainly introduce the student to the concept of the law of diminishing utility, which leads, from a fairness argument, to the concept of a progressive tax structure.

For example, a person who earns $90,000 per month attaches less importance to $10. But a man who gets $1000 per month, the value of $10 to him is very high. A finance minister knowing this fact that the utility of money to a rich man is high and to poor man low bases the system of taxation in such a way that the rich persons are taxed at a progressive rate. The system of modern taxation is therefore, based on the law of diminishing marginal utility.
Ref: http://economicsconcepts.com/law_diminishing_marginal_utility.htm

So, while the candidates try to use a flat tax to appeal to the voters, in a gesture with no hope of ever becoming law, what they might find more success with, in a manner consistent with basic principles of human behavior, is a “fair flat tax”.

The figure below illustrates graphically the three forms:

In red we see the current tax code, idealized with a smooth curve, it starts with a low rate and steps up to a maximum rate of 35%. We also observe some of the special interests … these exceptions to the tax rules are sometimes very small divots in the collections (how many llama farmersare there, anyway?). Sometimes they are larger (oil companies come to mind) and sometimes they are simply politically powerful special interests (renewable energy companies). Some even experience negative tax rates due to grants and the like.

In blue we see the simple flat tax as proposed by Perry. At 20% (which seems to reflect Hauser’s Law), it is simple in theory, but is not really fair. The person earning $20K per years will miss much more from the tax of $4K than the person making $100K will miss the $20K. The former may miss some meals, the latter may miss some trips to restaurants.

In black we see a progressive flat tax. This correctly recognizes the decreasing marginal utility of money as a function of income (itself a surrogate for wealth, against which real marginal utility must be measured).

Both the blue and the black lines promise the most important feature of the flat taxes, which is that there are no special breaks, making both “flat” when compared to the current tax codes. If Republican candidates were able to make their proposals look like the black “fair flat tax”, then the editorials would have to take them seriously and the cartoonists would have to find honest ways to make a living. As long as we don’t add the word “progressive” we will never make it past the late night comedy show monologues and the editorial cartoonists, and lacking any meaningful dialog, we (the taxpayers who fund all this silliness) shall surely lose.